By Jon Gregory
The 1st decade of the twenty first Century has been disastrous for monetary associations, derivatives and chance administration. Counterparty credits probability has turn into the main part of monetary probability administration, highlighted via the financial disaster of the funding financial institution Lehman Brothers and failure of alternative excessive profile associations comparable to endure Sterns, AIG, Fannie Mae and Freddie Mac. The unexpected realisation of intensive counterparty hazards has seriously compromised the health and wellbeing of world monetary markets. Counterparty threat is now a key challenge for all monetary institutions.This booklet explains the emergence of counterparty probability in the course of the fresh credits difficulty. The quantification of firm-wide credits publicity for buying and selling desks and companies is mentioned along hazard mitigation tools equivalent to netting and collateral administration (margining). Banks and different monetary associations were lately constructing their functions for pricing counterparty danger and those parts are thought of intimately through a characterisation of credits price adjustment (CVA). the consequences of an establishment valuing their very own default through debt price adjustment (DVA) also are thought of at size. Hedging facets, including the linked tools comparable to credits defaults swaps (CDSs) and contingent CDS (CCDS) are defined in full.A key characteristic of the credits concern has been the realisation of wrong-way hazards illustrated via the failure of monoline insurance firms. Wrong-way counterparty dangers are addressed intimately in terms of rate of interest, foreign currency echange, commodity and, specifically, credits by-product items. Portfolio counterparty threat is roofed, including the regulatory elements as outlined via the Basel II capital requisites. The administration of counterparty hazard inside an establishment is additionally mentioned intimately. ultimately, the layout and advantages of primary clearing, a up to date improvement to aim to manage the swift development of counterparty possibility, is considered.This booklet is exclusive in being virtually targeted but in addition overlaying the extra technical points. it really is a useful whole reference consultant for any industry practitioner with any accountability or curiosity in the sector of counterparty credits chance.
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Additional resources for Counterparty Credit Risk: The new challenge for global financial markets (The Wiley Finance Series)
Inevitably, it will be signiﬁcantly bigger than that in the previous case of buying bonds outright. 2 Market structure The derivatives market has grown exponentially over the last two decades. Derivatives have been shown to have many uses and have fuelled an increase in the eﬃciency of ﬁnancial markets. However, derivatives have been repeatedly shown to be capable of creating major market disturbances. They have been given such labels as ‘‘ﬁnancial weapons of mass destruction’’. The fact is that, as any invention that oﬀers signiﬁcant advantages such as commercial aircraft or nuclear power, derivatives can be extremely dangerous.
Such credit events will be described in greater depth in Chapter 6. 22 Counterparty Credit Risk tend to have an increasing default probability over time whilst a poor credit quality counterparty will be more likely to default in the short term and less likely to do so in the longer term. The term structure of default is very important to consider as the following example demonstrates: A trader has to assess the expected loss on a new FX forward trade due to counterparty risk. The potential loss at the maturity of the trade is estimated to be 10% whilst the default probability of the counterparty over the 5-year period is also 10%.
Derivatives traded on an exchange are normally considered to have no counterparty risk since the only aspect of concern is the solvency of the exchange itself. Due to the need for customisation, a much greater notional amount of derivatives are traded OTC. OTC derivatives are traded bilaterally between two parties and each party takes counterparty risk to the other. 1. The expansion has been driven primarily by interest rate products and then foreign exchange instruments with new markets such as credit derivatives (credit default swaps) contributing also (the credit default swap market increased by a factor of 10 between the end of 2003 and end of 2008).